Volatility – Platonicity

This is a long-winded piece with tons of embedded reading material.  My (Volar’s) goal is to get you all to not only think differently-  like ThinkTwice (a decent book FWIW). As for Platonicity, read Taleb’s stuff. I just get utterly annoyed when traders must have answers to questions with no answers, and when traders give reasons for cause and effect without giving any credit to randomness.  FWIW, if you like my work, go here and here to see Artemis Capital’s work (good stuff).

I urge all traders too look at this diagram above closely. Traders must understand their inherent limitations; they must understand logic (reasoning). I truly encourage every trader to read a book or two on logical fallacies. After a few good reads, you will (1) ignore news (2) lose the ego (3)  lose emotions (4) focus on relevant variables (5) give up predicting and (6) start managing losses, not winnings . The market does not take kindly to those who have an ego. In fact, if you don’t understand logical fallacies such as cum and/or post hoc ergo propter hoc, I am fairly sure it is only a matter of time before you go broke. Same for affirming the consequent.

From my general observations, I have found over 70% of traders watch only price. They ignore volume, open interest, money flow, sentiment, seasonality, the volatility “vega/gamma” market , and breadth.  They then turn on the news and hope the news influences price in their favor. I am not saying price is not good (there is true value in simplicity), I am saying if you are going to use 95 indicators, why should all 95 be based solely on price? Markets are not just price- price is the result of a complex multifaceted marketplace. As for news, if you presume news matters, you are naive. It matters, we just dont know how it matters. It is unmeasurable, non-consistent, circumstantial,  and of course, distributed by incompetent/biased touts and media whores. Traders must filter data (not news) to find what matters. What you do not see still matters– knowing that you do not know something is knowing something…

If you need proof that news does not matter, go here for a superb read. It “Misleads us systematically, it is irrelevant, it limits our understanding, it is toxic to our bodies, it increases cognitive errors, and etc. etc.”

OK – enough of that philosophical ranting.

I have been working on a project that looks at volatility from a different angle or two.

99% of the market looks at the VIX, but they ignore shape of IV (implied volatility). I mean how many of you rats really know what the VIX is, yet trust it each day?

Ahem… here is a start:

How many of you have had VXX stick it to you and you dont know why? How many blissfully ignorant sheep do TA on the VXX, USO, UNG every single day for no real reason? Ugh.

So what I am trying to say is that a trader needs to look at not just the VIX, but the VXV (VIX futures) & the Option “Smile.” The vega market can not be quantified in one data point (eg the VIX); hence, the “Platonicity” comment. Again what you do not see still matters.

First, lets look at what I mean by “smile.” Smile is the shape of option chain for a particular month (or the IV for different strike levels). I call this the vertical IV curve. Here is DEC 2011 Emini IV Smile.

Here is a good piece of intro on the smile.

The smile has been in the market since 1987. Traders no longer sell puts for cheap as true market distribution does have a one sided fat tail. At certain times that smile gets more extreme, and that means the MMs are worrying about some “black swan” event. Sometimes, like today, the smile is small; this means MMs are not too concerned about the end of the world. Albeit the smile is not flat (yet).

Now lets look at the volatility curve/time spread/ carry. I call this the horizontal IV curve.

Here is a link to for info on the VXV.

So you see, things are not linear here either. The carry is very similar to the smile in terms of sentiment/smart money. The Carry measures VOL over time, while the Smile measures VOL over different price levels. Or when the carry gets really wide (like bob the horse showed back in the day) it is quite bearish (LINK to ES POST). Why? Same as the smile. Option makers need to sell a higher vega on OTM to help offset a future event. Traders must trade the real  “estimated” distribution, which means they tend to lean different direction after/before certain events.

Here is a relatively useless way to make a cool graph that shows how the curve changes over time.

The market is inverted now, which means MM’s are betting vol does decline over time (the exact opposite before the correction). And the smile is not nearly as steep as it used to be (the exact opposite before the correction).

Remember MMs can hedge an option position in 2 directions: (1) they hedge and/or spread an ATM IV with an OTM IV (a vertical IV spread); or (2) hedge and/or spread any near-term IV with a back dated IV (Horizontal spread). The latter pertains to the entire reason VIX futures were made.

Now, on to some “expensive” $29 worth of cool crap you wont find elsewhere… The VIX has two curves, and I recommend watching them very closely. I would love to give this stuff away for free, but honestly, that whopping $29 filters much riffraff (GG the exception), and that just makes conversations here much more fruitful and constructive. I recall when I first started trading and I thought $150-$300 per month for data was ridiculousness. I can assure, it is worth its value- remember the market is comprised of many and it is a far cry from a democracy.

Now I am going to convey the data in a meaningful manner- or something we can use.

First we need to define boundaries for our measures of volatility. Or we need to measure the carry (horizontal curve) and the smile (vertical curve). We need to measure the non-linearity and see what has happened in the past. That way we can form the “do” and “do not know” categories. 3-d graphs do a poor job of doing that.

Lets start with the carry. One could use the VIX futures, but I have limmited data there, and the VXV (a 3M IV) is just a better piece of data. So I am using the VXV, which will measure the spread btwn 3M IV and 1M IV since 2002.

Clearly we are extreme. This is quite bullish. The inverted curve means MMs expect IV to decline to some degree.

Now lets look at the Smile. The smile is also called a skew (statistically the smile is pricing in a 1 sided fat tail event).

So it is one thing for the VIX to be “low” or high, but it is another thing if MMS are betting on a tail event (or not). The VIX is a bell curve, the Skew is the shape of the bell curve (aka a directional view of the VIX).

This shows that we have been more extreme, but it also suggests traders are no longer aggressively paying higher vol for OTM puts. Which means they believe the market actually has more upside risk than downside (for the time being).

What does all of that mean?

This means that MMS believe IV will drop over time, but they still can reduce the skew a bit more. That simply means MMs think more downside is possible in the short-term, but not  really in the long term.

Finally, I leave you with a composite black swan index of two non-linear measures of the Vega market. I use this bc it shows when (1) the VIX curve (horizontal) is inverted/low carry; and (2) the VIX smile (vertical) is relatively low.

So this gives us a quantifiable indicator of black swans. I know, black swans are not predictable. *But* keep in mind when the VIX drops, sentiment rises, traders must hedge against an event. Markets just do that, they grind up, and flush south. Nothing new here.

This would suggest that yes we could get more extreme, but overall the damage is likely done.

Bottom Line:

The VIX is great, but it does not tell the whole story. Just because you think you know volatility does not mean you know volatility; things are not black and white.  The VIX is generally a “dumb money” indicator, while the VIX curve and skew are “smart money” indicators. This is very bullish short-term, but it is unclear if the long-term low is established.

We are in a bear market until proven otherwise.

Good luck trading,

-Volar I am on vacation next week – I will be having a well-deserved rest in Charleston South Carolina – should be fun 🙂

Oh and if any of you believe in the death cross, look here